Education Management Corporation (NASDAQ:EDMC) is a for-profit provider of higher education that operates 101 primary campuses in 31 states and Canada with an enrollment as of April, 2011, of over 148,000 students. EDMC is the second largest chain of for profit-colleges in the United States, behind the Apollo Group (NASDAQ:APOL), which owns the wide-spread University of Phoenix brand. EDMC's share price closed at $16.64 on Friday, August 19th, down $11.97 from its $28.61 52-week high. EDMC has a price to earnings ratio of 10.02, and a market cap of $2.2 billion. The company currently pays no dividends.
Originally filed in March of this year as a whistleblower suit, the suit in question centers around alleged false claims made to the Federal government by EDMC. Specifically, the plaintiffs allege that EDMC knowingly made false claims to the United States and several state governments regarding recruiter compensation. The specific statute singled out by the plaintiffs is 20 U.S.C. § 1094(a)(20), requires that schools, "Will not provide any commission, bonus, or other incentive payment based directly or indirectly on success in securing enrollments or financial aid to any persons or entities engaged in any student recruiting or admission activities or in making decisions regarding the award of student financial assistance..." Under Title IV, any school seeking to receive student aid from the federal government must agree to abide by the above statute. The plaintiffs allege that EDMC's recruiter compensation was structured in such a way as to violate the provisions of the above statute and thus any claims made for federal aid on behalf students are actionable under the False Claims Act. The total amount of federal aid the government alleges was illegally obtained exceeds $11 billion.
While the suit spells out several other claims that the Federal government and states are seeking recovery under, the False Claims Act cause of action, if sustained, will be more than sufficient to bankrupt EDMC several times over.
The False Claims Act
Originally passed during the civil war as a means to prevent shoddy equipment from being sold to the United States, the False Claims Act is the single most effective weapon taxpayers have to battle the perennial campaign slogan concept of "fraud, waste and abuse". It is the author's personal belief that the government is seeking recovery under subsection (a)(1)(NYSE:B) of the act, which seeks to punish anyone who "knowingly makes, uses, or causes to be made or used, a false record or statement material to a false or fraudulent claim".
As an incentive to root out false claims made to the government, the United States has allowed whistleblowers to bring suits on its behalf in false claims actions. Whistleblowers typically receive a portion (commonly 15-25%) of the recovery obtained through the suit. Such actions are known as "qui tam" suits, and are typically only used in false claims actions. This particular action was brought by two whistleblowers who were employed by EDMC from 2006-07. The U.S. and the indicated state governments intervened in the suit as plaintiffs on August 8th, 2011. The individual states are pursuing recovery from EDMC under their own false claim act statutes. As of this writing Kentucky has joined the suit as a plaintiff and Pennsylvania has been barred from joining the suit, as the state does not have a False Claims Act statute. Pennsylvania's Attorney General's office has said that their office are reviewing statutes which may allow them to join the suit under a different cause of action.
The Government's Argument
Simply put, the government is arguing that due to the structure of EDMC's recruiter compensation it was in violation of Title IV, and thus EDMC's students were ineligible to receive government aid. If the government's argument is proven, every claim submitted for a government loan or grant is actionable. These claims span a time frame of over a decade and likely number between mid-six to very low-seven figures. The key point is that the government need not prove that any of the individual claims were materially deficient. If the government can prove that EDMC's recruiter compensation structure relied solely on the number of students recruited then every claim for student aid submitted by the company will be considered actionable under the False Claims Act. Indiana, the state with likely the fewest amount of claims, has identified 16,814 individual claims that it believes will qualify under the False Claims Act.
The Possible Damage
Companies face litigation all of the time, a quick Google news search will yield lawsuits filed against DNDN, RVBD, MILL, RIMM, NFLX, and several other publicly traded companies, all within the past few days. Most of these suits will amount to nothing and (not surprisingly) tend to show up when a company misses earnings. Other lawsuits can hurt a companies bottom line, costing shareholders through reduced earnings brought on by legal fees and judgments. Every once in awhile a lawsuit gets filed that has the potential to eviscerate a public company, I believe that this suit against EDMC qualifies as just such a suit.
The False Claims Act of the United States, as well as the False Claims Acts of the individual state plaintiffs, carry with them severe penalties. Two features of the False Claims Act make it an especially onerous law to be caught on the wrong side of. The first is that plaintiffs under the False Claims Act are entitled to recover treble (3x) damages from defendants. This provision, while seemingly incredibly harsh, was a feature installed to ensure that defrauding the U.S. government was not seen as an interest free loan.
The second feature of the False Claims Act is a per-false-claim penalty. This feature entitles the plaintiff to collect a fine for each false claim that is proven. Indiana's penalty is the least stringent among the plaintiffs represented at $5,000 minimum per claim. For demonstration purposes, ff proven, and if Indiana is awarded only the minimum fine, EDMC will be liable for a penalty of at least $84 million, over 1/3 of the company's TTM earnings. Keep in mind that figure is before any actual damages are assessed, and the $84 million would cover fines awarded only to the State of Indiana. The likely much higher amount of claims that would qualify by the 3 more populous states, as well as the federal government, would dwarf this figure several times over.
While actual damages suffered by each plaintiff are impossible to calculate given the current early status of litigation, we can use general figures from the industry to estimate EDMC's student aid default rate. Unfortunately, we don't know what percentage of aid granted to EDMC's students were loans and what percentage were grants. However, using the industry-wide default rate of 25%, and multiplying it by the amount of federal aid received ($11 billion), and then trebling the product as per the False Claims Act, we arrive at a figure of $8.25 billion as a very crude estimate for damages that would be awarded to the federal government. This number is not inclusive of damages that would be awarded to the states, nor is it inclusive of any fines leveled under the fine provision of the False Claims Act.
Note regarding the states's suits:
I did not feel it was necessary to analyze the possible liability of EDMC regarding damages sought by each individual state. If the federal government is even modestly successful in its suit against EDMC then where will likely not be much left of the company for the states to pick over.
The current suit against EDMC stands the possibility of bankrupting the company. Worst-case liability for the company exceeds several times EDMC's market capitalization and is at least an order of magnitude greater than the company's TTM earnings. Even a comparatively benign outcome for EDMC could see several years of earnings wiped away in a judgment. As always, the lengthy nature of litigation and the fact that the suit is still in the very earliest stages could force EDMC shorts to wait awhile before they see any gains.
- Read the original qui tam complaint here
- Read the U.S. government, FL, CA, IN, and IL joint complaint here
- Read the Department of Justice's press release regarding the suit here
- Read the text of the United States' False Claims Act here
- KY AG joins suit against EMDC here
Disclosure: I have no position in any of the stocks mentioned but may initiate a short position in EDMC should the suit proceed to trial.